Financial planner Bill Hoeschele puts all of his clients into the same investment before suggesting any others. It’s cash.
“If they don’t have anything else, that’s the first thing I ask them to do,” said Hoeschele, a certified financial planner in Lenexa, Calif.
Most advisers would agree.
Just about everyone ought to put aside emergency money before picking stocks, bonds, mutual funds, precious metals or other types of assets to invest in. The idea is that if all of your money is tied up in long-term investments, an emergency might force you to sell at an unreasonable loss if prices happen to be in a slump.
A cash stash anticipates the possibility of such things as a sudden job loss, car failure, fire damage, prolonged sickness or a big dental bill.
Opinions vary as to how much emergency cash a good financial plan should contain. Debate also surfaces around the choices of where to put the cash. The conventional thinking is most of us should sit on enough cash to cover three to six months of our living expenses. Suggesting this is a lot easier than calculating a dollar amount. You’ll first have to build a budget to know what one month’s expenses are.
James Stowers, founder of American Century Investments in Kansas City, adopts that rule in his book, “Yes You Can . . . Achieve Financial Independence” (Deer Publishing Co.; $24.95).
Where to peg your emergency fund within that range is a matter of choice. The smaller the amount, the less emergency you’ll be able to handle. But a larger cash hoard drains more money from your investment portfolio.
Six months of expenses drains too much from the investment pool, contends financial writer Jonathan Clements. He cites the six-month rule as Myth No. 15 in his book “25 Myths You’ve Got to Avoid if You Want to Manage Your Money Right” (Simon & Schuster; $23).
Three months is enough, he writes, albeit with an exception.
“If you are constantly in danger of getting laid off, maybe this (six-months) rule really does make sense. But for the rest of us, I think it’s ludicrous,” he writes.
Hoeschele uses the three-to-six-months rule. “I very seldom change it,” he said.
But he’s willing to tell clients a sharp break in the stock market might justify moving maybe half of the money out of the cash hoard and into investments. The “emergency” in this case would be the sudden buying opportunity.
“If you had cash, you could buy a couple of stocks you’ve been watching,” Hoeschele said, adding that the next step should be to start rebuilding the emergency fund to the original target.
The second big issue for your cash hoard is where to put it.
The mattress is out. Although you don’t want to put this money at risk, it ought to earn something during the years it sits around.
Stowers’ book identifies three traits a cash investment should have. It should keep the money readily available, it should be safe, and it should produce income.
He likes banks, credit unions and savings associations, deposits in each of which are federally insured up to $100,000 per account. The best rates available will be on their money market deposit accounts and certificates of deposit.
Bank money market accounts up to $10,000 currently earn an average 2.98 percent yield, according to an Internet listing by Bank Rate Monitor (www.bankrate.com). The average yield jumps to 2.98 percent for balances of more than $10,000, the listing shows.
You’ll average more in a CD–4.10 percent in a three-month CD, the BRM listing shows. But this means the money isn’t immediately available in an emergency without paying an early withdrawal penalty.
Hoeschele said he didn’t recommend CDs for emergency funds but added the penalty for cashing in a three-month CD isn’t prohibitive.
Hoeschele’s suggestion is to put emergency money in a money market mutual fund. Stowers, whose company sells mutual funds, naturally includes money market mutual funds in his short list of cash investments. And Clements, who doesn’t sell funds, suggests money market funds, too.
The reason is return. Money market mutual funds are paying an average 4.91 percent, according to an on-line listing by IBC’s Money Fund Report (www.ibcdata.com). Money funds that own only government securities (making them a bit safer) are averaging 4.78 percent, the report said.
Money market funds pay more than federally insured accounts because they are not federally insured. Uncle Sam will bail you out if the bank fails–but won’t if the fund fails.
But the fund company probably would. When one money market fund’s price dipped below the $1 selling price in 1994, the fund company dipped into its own pocket to keep investors whole.
Hoeschele said investors in government-only money funds should take the added yield and not worry about the lack of federal insurance.
“That’s about the safest money you’re going to get,” he said.
Clements’ book and an August 1997 article in Smart Money magazine have suggested taking a little more risk with your emergency fund to get still more gain.
The ideas include putting some of the money into short-term bonds or short-term bond funds, buying stripped Treasury securities and investing in loan participation funds or even stocks.
These choices would pay more than a money market mutual fund because they carry more risk–their prices can fall.
For example, rising interest rates can push down the market price of a bond after you buy it. You’ll get all your money back if you hold the bond until it matures, but if an emergency forces you to sell when the bond’s price is down, you’re stuck with the loss.
Such short-term losses are possible with stripped Treasuries and loan participation funds, too. You’ll also have to pay some fees with each of these investments.
In his book, Clements suggests you put all but a few thousand dollars of your emergency money into a stock mutual fund. And if the stock market is down when you need the cash, borrow on credit cards or against the equity in your home. Then, he advises, repay the debts once the stock market has recovered the temporary loss in your emergency fund. It’s easy to see, however, that’s pretty much the same as not having an emergency fund.
